Month: June 2018

In modern economic theory “competition” is used to describe a state of affairs that is probably best thought of as being the CONCLUSION of a competitive process adjusting to fixed underlying conditions. Something as simple as charging the same price is unlikely outside of the most organized markets. Yet, this is a key feature of the perfect competition model.

The common speech sense of competition understands competition to be a dynamic process – one that is typified by people finding and exploiting differences between themselves and their competitors. This is directly opposed to the perfect competition model which assumes a similarity between firms (and certainly between products!).

Making a fetish of the perfect competition model can lead to odd results – in particular, the suppression of an actual competitive process by the use of regulation to impose standardization.

A more productive path than comparing the real world to a hypothetical world of perfect competition is to compare the real world with competition as commonly understood with the real world with competition (as a process) suppressed by legislation. If we allow the competitive process to occur, entrepreneurs will continually adjust their products and processes to try to produce goods that best serve consumers at the best possible prices. Failure to serve consumers’ demands for quality and price will result in losing business to competitors. On the other hand, suppressing competition – perhaps by using price regulation to enforce a common price – will tend to suppress the desire to serve consumers well and efficiently.

This summarizes a section of Ludwig von Mises’s Socialism titled “Economic Calculation”, available from the Mises Institute and Amazon.

Value is fundamentally subjective. For a single consumer, comparing the values of different consumer goods is fairly straightforward. Similarly, comparing the values of factors of production in fairly simple production processes is also fairly straightforward, as the connection between the factors of production and the resulting consumer goods are clear. However, once the production processes achieve any significant degree of complexity, a direct value comparison becomes impossible – especially since there are typically a multitude of possible methods of producing any particular good. In order to deal with this situation, we need economic calculation – the calculation of profits, losses, and equity.

Economic calculation requires two conditions: first, there must be exchange of the factors of production. (This is why socialism – which Mises uses in the strict sense of government control of the means of production – can’t calculate. With government controlling all the means of production, there can be no exchange of them.) Second, it must be a monetary economy. With these two conditions, factors will have money prices, which can be used to calculate costs, profit, and equity.

Economic calculation is not perfect. It cannot account for certain “non-economic” considerations. (Mises cites the example of a productive process that destroys the beauty of the natural landscape.) However, without economic calculation, there is no clear guide for how to produce what we would like to produce.

Socialism can stumble along for a bit, if it holds to the old pattern of production. Since preferences and resources usually don’t change very quickly, the old pattern of production won’t be far from the right one at first. However, in the real world, change happens – which means that holding to the old production patterns would cease to be rational as time passes.

One of the primary contributions of the Austrian school was moving from thinking of goods and people in terms of “classes” to think of them in individual units and as individual people. This emphasis on the individual provided three main insights.

(1) The Law of Diminishing Marginal Utility – while classical economics was stuck on the paradox of value (best seen in the diamond-water paradox, which points out that water is essential for life but cheap while diamonds are mere decoration but are expensive) and had to propose that there was a disconnect between use value and exchange value, Carl Menger pointed out that this paradox is resolved if we think about the usefulness of an additional (that is to say, marginal) unit of the good. While water, as a class, may be very important, the reality is that we have so much of it available in most places that humans live that ADDITIONAL water isn’t really very useful. As a result, water is cheap – we’re not willing to pay much to get more than we already have. Diamonds, however, are very rare. So, we are willing to pay a lot to get an additional one. By thinking in terms of exchanging individual units of the good, Austrians could discover this law of diminishing marginal utility – which connects exchange value with (marginal) use value.

(2) Time Preference – where does interest come from? With their faulty value theory, classical economists were stuck going one of two directions. One group – which led to the Marxian view – suggested that interest was a kind of “surplus value”. The labor embodied in the good was what gave it value, so if the exchange value was greater than that intrinsic value, then the difference was a “surplus” of value. Another group suggested that capital is productive. So, the reason that capitalists earn interest or profit is because they own productive resources. However, both of these views are incorrect. Austrian economist Eugen von Bohm-Bawerk builds on Menger’s individualist view of value to show that what distinguishes capital is not its exploitative nature (which competition between employers would diminish) nor its productivity (which should be fully embodied in the price of the capital good when it is purchased). Rather, it is time. When an individual acts, they demonstrate a preference for sooner want-fulfillment to later want-fulfillment. What a capitalist does, then, is pay for the production of a good up front – knowing that they won’t get the revenue until later. They would only do this if they expect the revenue to be enough greater than the cost that it is worthwhile to delay gratification. That is: if they receive interest. Meanwhile, workers are willing to work at a “discount” below the value of the product precisely because they do not have to wait for the final product to be sold before they receive their pay. They are willing to sacrifice some money in order to get their pay sooner rather than later.

(3) The law of diminishing marginal productivity – finally, thinking in terms of individual units allows for the Austrians to explain, for example, wages (and other factor prices). Factors are paid according to their marginal productivity – that is what an additional unit of the factor would add to production. We can’t arbitrarily divide production of goods from distribution of income. Rather the two are intimately connected. Distribution of income is not arbitrary – rather it comes about as a result of marginal productivity. This thinking also changes the question of class dynamics. Laborers and capitalists should not fight over how to distribute goods between them – the two are partners, as labor and capital are typically complements. (That is, most of the time, having more capital makes labor more productive – raising wages, while having more laborers makes capital more productive as well!) Rather, the conflict should be between members of the SAME class. Rothbard’s example: a new discovery of copper doesn’t hurt workers (who will now have additional jobs available) or consumers (who will find that copper goods are cheaper). It hurts those who ALREADY PRODUCE copper, as they see the price of their product decline. So, then, the Marxian approach suggesting there is some fundamental conflict between labor and capital is incorrect. Rather, conflict exists WITHIN each of these classes – labor v labor and capital v capital.

Planning for Freedom – interventionists claim that their version of economic planning is radically different from the socialists’ as well as the capitalists’. They claim to be able to achieve a best of both worlds. However, interventionism tends to create results that are counter to the stated intent. For example, minimum wage, rather than lifting all workers (and especially the least fortunate) tend to lift some workers’ wages while disemploying others entirely. Similarly, high union wages tend to end up suppressing nonunion wages. If we want to help everyone, we should allow for a maximum of freedom, which will encourage entrepreneurs to produce what consumers want and to do so as productively as possible (raising wages).

Middle of the Road Policy Leads to Socialism – Following from the previous chapter, the middle of the road policy tends to be a road to socialism (that is, full government control of the economy). Consider a price control on milk – which is intended to make milk more affordable and available to the lower classes. However, the price ceiling will lead some farmers to produce less milk – instead they’ll produce things like butter or cheese which are not price controlled. So, milk may be cheaper, but it is less available than before. To offset this, the government would have to place price controls on the inputs (and perhaps the other goods that milk producers would be tempted to switch to), so that it is profitable to produce milk even at the lower price. This would simply lead to fewer of those inputs being made available – leading to yet more price controls being needed. In the end, the government would have to take over control of all production in order to meet its goal of providing more, affordable milk – just as in full socialism. This path is not mere conjecture – it was largely along this path that the British economy became socialist through World War 2, and that the German economy became socialist (of the Nazi variety) in the lead up to World War 2. The march toward socialism is, however, reversible, if the people adopt an ideology that is not simply anti-communist and anti-socialist, but is a positive endorsement of the market system that has led to the prosperity we have.

Introduction – What distinguishes the Austrian school: (1) devotion to a deductive method aimed at conceptual understanding, (2) methodological individualism – seeing economic phenomena as the result of individual actions.

The Subjective Theory of Value – Value is fundamentally subjective. Even prices are the result of subjective valuations of amounts of money (and their expected eventual use) and the goods that are being traded for that money. Producing for exchange means that we need to consider not only our own preferences, but also the preferences of our buyers. The fact of subjective preference suggests that there is no “economic man” who is bound purely by monetary calculations. Rather, monetary concerns are balanced against other concerns as well. For example, anticipating modern behavioral economics and the idea of “bounded rationality”, Bohm-Bawerk points out that the process of economic calculation is, in itself, costly in terms of time and effort. So, for trivial matters, it is probably best to follow general heuristics, saving the effort of monetary calculation for larger matters where precision is more important.

The Individual in Society – This chapter is about the meaning of “freedom”. Mises suggests that there is no such thing as “freedom” from nature. All people are bound by scientific laws. To be meaningful, “freedom” then is freedom from the arbitrarily imposed will of others. At the same time, complete freedom from the influence of others would come at the price of abandoning all social relations. A market economy based on private property allows for interactions that enhance our productivity, while still allowing people to be free from compulsion and coercion. Historically, those who want to subvert freedom have tended to shift the definitions of terms – suggesting that employees are “wage slaves” rather than being really free, for example.

The Elite Under Capitalism – People are born unequal in certain respects – leading to “superior” and “inferior” people. In precapitalist societies, the superior used violence to take advantage of the inferior. In the market economy, the superior can only benefit by serving the inferior – producing products that the inferior are willing to pay enough for. So, in a market economy, the consumers – most of whom belong to the “inferior” group – end up “ruling” the superior – in that it is the masses of consumers that determine how profitable a business will be.

In my previous post, I explained a bit about how whole life insurance works – in particular trying to explain the idea of “cash value” and where it actually comes from. (Something that both the industry and critics get wrong, with just one exception that I’ve found.) This explanation was sought out and brought on by interest in the Infinite Banking Concept (IBC) or Bank on Yourself (BOY).

The basic idea: when structured carefully, a whole life insurance policy can be used as a savings instrument that can replace your need to take loans from banks. It’s really that simple. Now, let’s get into the “how” and “should I”?

How Does It Work?

As I previously explained, whole life insurance policies build up a cash value – which is basically a buyout offer from the insurance company to get you to cancel your policy so they can avoid paying the large death benefit. In order to maximize that buyout offer, you need to carefully structure your life insurance policy so that it’s worthwhile to buy you out quickly. How you do that: structure things so that you pay the premiums early in the policy.

At the extreme end, you would buy a “paid up” policy where you only pay once. And, this policy DOES build up cash value fastest. If you wanted to invest, say, $1000 per year, buying a paid up policy each year would build up cash value MUCH faster than getting a basic whole life insurance policy with a $1000/yr annual premium. But, there’s a catch: taxes.

For whatever reason, the government has decided that earnings in life insurance policies shouldn’t be taxed as long as you don’t access them until late in life (or after death…). This is a handy benefit. HOWEVER, the government has also decided that paid-up insurance isn’t REALLY insurance. It’s just an investment – called a “modified endowment contract” or MEC. So, using the “buy a paid-up policy each year” plan would result in negative tax consequences.

So, Infinite Banking/Bank on Yourself set out to maximize your cash value while, at the same time, avoiding the negative tax consequences. So, here’s what they do (this is from Bank on Yourself):

(1) Start with a standard whole life insurance policy with a smallish death benefit.

(2) Tack on a Paid-up Additions Rider – in effect, this rider lets you ADD paid-up insurance to your standard policy. As long as the proportions are right, since the tax man analyzes the policy AS A WHOLE (basic policy PLUS the riders), this can allow you to build up cash value more quickly than the basic policy would while still avoiding the negative tax consequences of an MEC.

(3) Tack on a Term Insurance Rider – this increases your death benefit for fairly cheap. Since the MEC determination is based on a comparison of your premiums vs. the death benefit, this rider allows you to put MORE into paid-up additions. Eventually, you can let this rider expire if you follow the Bank on Yourself method. The dividends you get from the whole life insurance policy will build up your death benefit to the point where you don’t need the term rider to allow the larger paid-up additions.

Sound complicated? That’s okay. This is why Infinite Banking and Bank on Yourself recommend that you NOT try to cobble this thing together on your own. Instead, both are assembling teams of agents who are trained in their techniques – which are pretty similar to each other, as far as that goes. And, unfortunately, life insurance is so highly individualized that you kind of HAVE to talk to an agent about your case. (Or is it just me that hates to talk to people trying to sell me things?) I’m just laying out the basics so you have some clue what’s going on.

Once you’ve built up a cash value, you can then access it in one of two ways:

(1) you can withdraw as much as you have put in – this involves a partial buyout, so you sacrifice some death benefit. (Withdrawing more than this sparks tax problems.)

(2) you can borrow from the insurance company, using the cash value as collateral – this allows the cash value to continue accumulating and does not sacrifice death benefit. If you happen to die before you pay the loan off, then the insurance company will subtract the amount of the loan from the death benefit. This option allows you to use the FULL cash value now (at least as I understand it…) – not just the premiums that you put in. Of course you have to pay it back, or the interest (interest rate 8% from what I’ve seen) may accumulate to the point where the insurance company cashes in your policy for you to make sure the loan gets paid. Basically, like with a bank, you can withdraw money from your account without putting it back in – it just means it’s not there in the future. And, like with a bank, if you don’t pay the loan you might lose the collateral. Policy loans are just a LOT more flexible than bank loans.

The Problem with Analyzing IBC/BOY

The problem I ran into: I like to analyze things myself without a sales person looking over my shoulder. So, I didn’t want to contact a trained agent to ask about the details for one of these policies. I would probably end up feeling guilty enough to buy one if I did that, just because they invested their time in talking to me. But, life insurance companies seem to keep information about their policies under lock and key. It’s VERY hard to get the detail I wanted without giving them my phone number so an agent could call me. (Something, by the way, that is RIGHT THERE in the fine print on the website – that I’m agreeing to have agents call me when I ask for information.) Since the structure of these policies is a bit complex, I couldn’t analyze them exactly.

But, I found something that could get me close. State Farm has decided that it might actually be worthwhile to provide some detailed information to people WITHOUT forcing them to give their contact information. So, I could run some scenarios through them. Awesome.

EXCEPT that they don’t let me tailor things in the IBC/BOY way. To be fair: IBC is less restrictive than BOY in terms of the policy structure, based on my limited understanding. It’s more a philosophy of how to structure these things. Some IBC advocates point out that a 10 pay policy (in which you pay premiums for just 10 years to get the death benefit for life) does a reasonably good job for IBC purposes. It satisfies the tax man’s definition of insurance, AND it builds cash value reasonably quickly. Best of all – I could actually get information about it from State Farm.

Analytical Method

From State Farm, I could use 2 values: the “Guaranteed Cash Value” (which assumed zero dividends) and an “Illustrated Cash Value” (which assumes reasonable, but certainly not extravagant, dividends).

The next choice I had to make: what should I compare this TO? I mean, it’s fairly obvious that, as long as the cash value eventually exceeds the total premiums I paid, it’s going to beat my savings account at my bank – which literally pays 0.1% right now – over the long run. That’s hardly a necessary comparison.

So, I took a page from Pamela Yellen of BOY. She seems to advocate (I’ve not finished the book, so I might be wrong here) replacing a 401(k) with a BOY policy. So, the obvious point of comparison would be stocks – or, more properly, a stock/bond mix like you might use in a 401(k).

Personally, I think a Roth IRA is a reasonable comparison. It has a lot in common with these policies. Earnings are tax-free, as long as they’re invested until you’re old enough (59 1/2). AND you can withdraw anything you put in without sparking tax consequences. The Roth has 2 restrictions these policies don’t: (1) You can only put in a set amount each year (for me, $5,500 for me and $5,500 for my wife). (2) You can’t borrow against the earnings. So, keep that in mind.

Here’s my method to do the Roth comparison:

(1) I looked up a 10 pay policy from State Farm for $100,000 (the smallest they offer of that policy type). Premium for me: $2784/yr.

(2) I looked up how much a 3o year $100,000 term life policy would cost. (answer: $216 per year)

(3) I subtracted $2784-$216 (the premium for the term policy) – $20 (likely annual commissions in a Roth account that is rebalanced once a year using TDAmeritrade).

Putting together 1-3, I’m assuming “buy term and invest the difference”. So, $2784 is going into the 10 pay policy in the one case, and $2784 is going into buying a term life policy ($216) + commissions ($20) + Roth contributions ($2548) in the other. This is for the first 10 years. After that, I’m assuming that the Roth IRA cashes out $216 per year to pay the term life premium.

I assume that the investments in the Roth will be a bit aggressive. 80% small-cap stocks (using the IJR ETF), and 20% in a boring bond fund that just pays 3% per year with no price volatility. (3% is the dividend yield on BND right now. BND isn’t old enough to fit my whole time frame, so I just assumed that bonds were held until maturity and earned 3% per year.) The Roth is rebalanced each year to ensure an 80/20 allocation. Also, because I assumed ETFs were used I don’t have to worry about any hidden expenses.

For time frame, I went back as far as I could. Turns out IJR has existed since 2001. This is GREAT – because it means we’ll capture BOTH the tail end of the dot-com burst (which was not good for small caps) AND the subprime crisis. So, we’ll see both a fairly “standard” stock market crash associated with a mild recession, AND a major “worst since 1929” crash followed by a prolonged, deeper recession.

80/20 Roth v. 10 Pay Life Insurance

So… what happens? Well, here you go:

In the early years the Roth outpaces the insurance policies – even through the tail end of the dot-com burst. The Roth keeps going up because of the contributions being made in this time, which are large enough relative to the existing balance to offset the losses.

At the end, the high average returns of stocks (especially small cap stocks) lead the Roth to outpace the insurance policies by quite a bit – so you end up with about 2x as much money at the end of this time as in either of the life insurance scenarios.

The only time frame where you should say “Oh, I’m so glad that I followed the insurance plan rather than the Roth plan.” is in 2009 – which reflects that the market collapsed amidst the financial crisis in 2008. But, the recovery was so fast that by as early as 2010, the Roth was ahead again.

[Note: one might think that the end result is affected by the fact that the Roth was still in the contributions phase during the crash. And that is true. However, I performed another analysis using SPY – which is an older ETF – over a longer time frame – so that contributions had stopped before 2009. The end result was still similar to above.]

In terms of total value, it’s pretty clear that the Roth wins in the long run. However, in terms of ACCESSIBLE value, it loses (as long as you’re not 59 1/2 yet!). The Roth had $25,480 go into it that can be withdrawn without tax consequences. Of that, $1,888 HAS been withdrawn to pay for the term life insurance – so only about $23,500 can be accessed without sparking tax consequences.

Meanwhile, of the $39,130 in the Guaranteed Cash Value in the life insurance, fully $27,840 can be withdrawn without having to repay AND without sparking tax consequences. OR the entire amount can be borrowed.

In addition, the Roth plan’s $100,000 insurance policy is going to run out in about 12 years (and will need about $2500 more in premiums). The $100,000 whole life insurance policy won’t, doesn’t need any more premiums, and the death benefit might grow. (In the illustrated version, the death benefit has grown to $103,602 by the last year analyzed, thanks to dividends.)

100% Bonds v 10 Pay Insurance

“BUT WAIT!” an IBC/BOY advocate may say. “Look at the roller coaster that is the Roth! If things had ended in early 2009, then IBC/BOY would have won.” I absolutely do not deny that. The issue is that, over the long term, 2008-2009 happens, but doesn’t stay around forever. Stocks do recover. So, their average return is what matters. And that beats what State Farm is telling me about their policy.

However, there are some really risk averse people out there. They just can’t stomach the idea that 2009 happens. Okay. Let’s compare a Roth portfolio (keeping the tax benefits) 100% in perfectly stable bonds paying 3% per year to the 10 Pay Insurance plan. Here, I’ll decrease commissions to $10 per year (since I’m just buying the bonds once a year, instead of having to rebalance between two investments), but continue the $216 term life insurance premium.

The results:

In the first few years the bonds win, since it takes time for significant cash value to build up in the insurance policies, but you have 100% access to all your contributions immediately with the bonds – but that reverses by year 8 (for the illustrated case) or 9 (for the guaranteed case).

Add to that, again, that in terms of immediately ACCESSIBLE value, the insurance policies obviously win around year 7 or so, as their cash value has grown past what has been contributed to the bonds in the Roth IRA at that point. AND that the term policy paired with the Roth is going to run out in 12 years (and require continuing premium payments in that time) while the whole life policies’ death benefit will never go away and might grow.

Conclusions

Weirdly, writing this blog entry led me in a direction I didn’t expect. I expected to conclude with something like “An 80% stock/20% bond Roth provides a better long run return and better short-run (less than 6 yr) access to contributions. Whole life policies really shine if you’re very risk averse – otherwise, go with a stock-heavy Roth.” Since I’m not particularly risk-averse, I figured I’d conclude that IBC/BOY was good for some people, but not for me.

But, I think that conclusion isn’t *quite* right. Now, don’t get me wrong. The 80/20 Roth DOES provide a better long-run return. And it DOES provide better short-run access to contributions for the first 6 years.

But, there’s another possibility I hadn’t considered.

The analysis shows that, over the long run (8-9+ years), a 10 pay policy IS an attractive alternative to super-safe investments in things like bonds, Certificates of Deposit, or savings accounts.

The fact is that EVERYONE should have SOME safe investments. Why not (gradually) REPLACE your bonds and savings accounts with whole life policies’ cash value?

I mean, bonds in a 401(k) or Roth IRA are long-term investments ANYWAY. And you can keep your cash emergency funds while you build up your cash value.

In the grand scheme: what about combining a smaller IBC/BOY policy with a Roth that gradually turns to 100% in stocks as the policy’s cash value grows? Basically, do the 80/2o thing, but, instead of it all being in the Roth, have the 20% in “bonds” be replaced with an IBC/BOY policy.

Some thoughts on this:

(1) Using this as a replacement for a larger life insurance policy probably wouldn’t be a great idea – so you’d still need to carry a term policy, at least until the stock portion of the Roth IRA grew enough to self-insure.

(2) Early on (years 1-7 or so), you’d still want to have some bonds in the Roth, as the cash value hasn’t caught up yet.

(3) You might be able to eliminate your need for a cash emergency fund. Since the purpose of a cash emergency fund is to have liquid savings available that will not lose value, the fact is that whole life insurance cash value FITS that. It just takes some time to build up. So, keep the cash emergency fund until the life insurance cash value catches up, then you can use the cash emergency fund to either buy more life insurance or to go into a Roth, 401(k), or some other riskier investment.

(4) This would be most effectively done with a flexible paid-up additions rider. This allows you to buy extra paid-up life insurance on your own schedule. The insurance company will be careful to make sure that you don’t accidentally convert your life insurance into an MEC by buying too much paid-up insurance.

In Brief

Based on my analysis, 10 pay life insurance is best seen as a replacement for long-term (7+ year) SAFE investments.

Now, I’m seriously considering taking part of my raise from next year and talking with someone about how I can get started in a whole life insurance policy…

About 15 years ago, I was introduced to the Infinite Banking Concept when I met Nelson Nash and his wife at the Mises Institute. He was giving out free copies of his book Becoming Your Own Banker. When I read it, I decided (1) it sounded very interesting and (2) I didn’t understand the thing at all, because I was unfamiliar with whole life insurance. So, all the examples just felt totally made up. And that was where I was for a long time. Then, just recently, I ran across this article by Robert P Murphy. He provided a key insight that let me understand how whole life insurance works. Here, I will share that with you in my own way – though reading Murphy’s article is also certainly worthwhile.

The Infinite Banking Concept

The basic idea behind infinite banking is that you can use whole life insurance as a saving instrument from which you can make withdrawals and take loans. Nash’s book shows that this is typically superior to simply saving using Certificates of Deposit (and certainly beats borrowing from a bank!) or something like that as long as you’re dealing in a reasonably long time frame.

Unlike term life insurance, whole life insurance builds up a “cash value”, which you’re allowed to access – in part or in whole – permanently or temporarily – before you die. And that’s really the key to the whole thing.

Nash’s book includes lots of tables showing the amount of cash value that builds up over time in different types of policies, and shows how you could access that cash to do things like give yourself a car loan, pay for retirement, pay for your kids’ college, etc. (Note: a lot of Infinite Banking is about carefully designing a whole life policy so that it builds cash value quickly while keeping the tax benefits that life insurance provides.)

The natural question I had: how does this cash value thing really work? I’m familiar with term life insurance – where you pay a (at my age, small) premium and if you happen to die in the agreed upon term, the life insurance company will give your beneficiaries a bunch of money. To understand whole life, then, it seemed I really just needed to get my mind around the “cash value”.

Cash Value Explained Badly

The typical explanation for cash value goes something like this… “Each year, we put part of your premium into accumulating cash value while the rest pays for the death benefit.” (from insurance companies) Or “Whole life insurance is a combination of an expensive insurance policy with a mediocre savings plan.” (from critics like Dave Ramsey)

This leads to a natural question: HOW MUCH of my premium is going into cash value each year? If you look for this answer, you can’t really find it. But, hey, I have Excel. I can make some assumptions and figure it out, right?

Wrong. All my attempts to do this ended up making no sense. Cash value doesn’t accumulate the way that you’d expect, say, money in a savings account to. It grows – but the rate of increase in the growth isn’t consistent. True, that’s probably because the % of your premium that goes into the cash value changes over time.

So, I recently used information I got from statefarm.com (which is the ONE insurer I could find that would give me a detailed statement of cash value over time without me having to give them my contact information – I am very averse to receiving sales calls…) to try to tease things out. With the premiums and cash value structure I got from State Farm, I could assume a rate of return on cash value, and then find out what the implied death benefit premiums were. Unsurprisingly, I found that the death benefit premium went up over time. This is what I’d expect. Since you get the death benefit when you die, you’re going to pay more for it if you’re closer to death. But, there were a couple surprising things: (1) The premium for the first couple years was ENORMOUS. Is it really that common for people to take out life insurance policies just before they commit suicide, so that your odds of death in year 1 are so big that a basic whole life policy should accumulate $0 of cash value for a couple years? (2) the premium rose at an increasing rate (not surprising) until you hit age 85, at which point the premium rises at a DECREASING rate. Okay, so I’m a LOT more likely to die at 85 than at 84 (I’ll grant that), but only a LITTLE more likely to die at 95 than 94? That feels a bit… wrong. But, I suppose I’ve not seen the mortality tables…

Another problem with this explanation: it opens whole life insurance up to the worst criticism against it. If you die, your estate does NOT get BOTH the cash value AND the death benefit. It just gets the death benefit. Now, defenders of Whole Life will say things like “if you sell your house, do you expect to get BOTH the equity you built up AND the whole sale price?” (from The Bank on Yourself Revolution by Pamela Yellen) But, this analogy is a bit goofy if we accept the “part goes to death benefit, part goes to cash value” explanation of whole life. When I use a mortgage to buy a house, the part of the home payment that doesn’t go to escrow is ENTIRELY used to pay down the home loan and its interest. I build up equity not because the bank is investing part of the money that I pay them into the house, but because the loan is getting smaller. So, are you saying that when I take out a whole life policy that the insurance company LENT me the policy, and I’m paying it off, so that I build up “equity”? If that’s the case, then why do I get the whole death benefit if I die early?

The better analogy based on the “part death benefit, part cash value” explanation is “buy term and invest the difference”. If I buy a term life insurance policy and also invest in something – stock, bonds, llama farms, whatever. When I die, my heirs get BOTH the life insurance death benefit AND my investments. So, using the “divided premium” explanation DOES make it look like whole life insurance is a big old scam to seize people’s investments when they die.

Good news! As Murphy explains: this explanation is just wrong.

Cash Value Explained Reasonably

Let’s take another stab at explaining cash value.

We’ve already mentioned one key difference between term and whole – the accumulation of cash value. But, there’s another, and it’s absolutely essential in understanding why cash value exists. If you pay your premiums on a term p0licy, you very well may still walk away with exactly $0. How? You don’t die during the agreed term. That is, in fact, what the life insurance company is hoping for.

If you pay your premiums on a whole life policy, you WILL walk away with the death benefit. Guaranteed. Either you’ll get it because you die (and since there is no expiration, you’re pretty well guaranteed to do that at some point), OR you’ll get it because the policy matures (which typically happens when you turn 121, now a days).

What that means, then, is that, from the life insurance company’s perspective, when you buy that $100,000 policy, they are going to be paying you $100,000 unless they can convince you to cancel it. The cash value, then, is really a BUYOUT. It’s an offer from the life insurance company to try to convince you to cancel the policy early so they DON’T have to pay the entire $100,000.

So, why does cash value grow over time? Two reasons: (1) early in the policy, you are least likely to die. Later you’re more likely. This increasing odds of a payout soon makes the life insurance more eager to get you to cancel. (2) early in the policy, you have lots of premiums to pay throughout the remainder of the policy. Later, you don’t. So, early on, if you cancel the policy, the insurance company loses decades of premiums they would receive. They don’t want to do that. But, later, when you’re closer to “death or 121”, you have fewer payments left to make. So, it doesn’t cost them much to have you cancel.

It’s the combination of (1) and (2) that lead the insurance company to want to make you a buyout offer that increases over time.

This ALSO explains why different variations with the same annual premium can provide very different cash values. Consider just 3 options: standard whole life, 10 pay, and paid-up. With the standard policy you pay the premium forever. With 10 pay, you pay premiums for just the first 10 years. with paid-up insurance, you just pay once. Naturally, for a given death benefit, you’ll pay MORE each year if you use 10 pay than a standard policy, and you’ll pay even more for the paid-up policy than you would for a single year’s premium on a 10 pay policy. In effect you’re “paying in advance” for these two structures. It turns out that if you shorten the pay period, you get cash value faster. Why? Because you’ve accelerated reason #2. With a standard policy, I would have possibly 80 years of additional payments coming – this dampens the insurance company’s enthusiasm when it offers me a buyout. But, with a 10 pay policy, I only have 9 additional payments after the first. They’re not losing much if they make a reasonable buyout – and are possibly saving themselves a big death benefit expense. With a paid-up policy, they ALREADY HAVE all the money they’re going to get – so there is no “expected future premiums” to offset their desire to make a buyout offer.

When you die, why don’t you get the cash value AND the death benefit? Because the cash value was a buyout offer to convince you to give up the death benefit. You didn’t take the buyout offer and got the death benefit instead.

So, why can you access this cash value through loans? The reason is fairly simple: the cash value is an asset with a guaranteed value. If I have an asset with a fairly clear value, I can take out a loan using that asset as collateral. Most obviously the case with mortgages and home equity loans, but, with pawn shops, you can do this with literally anything that has a reasonably clear resale value. In this case, it’s the insurance company which provides the asset (the buyout offer), so they’re certainly willing to lend you the money now – and don’t particularly care when you pay it back. At worst, they cancel your policy if the interest on the loan accumulates to more than the cash value is worth. So, no credit check is needed.

What about withdrawals? That’s easy to explain, too. What you’re doing with a withdrawal is taking a PARTIAL buyout. So, you can, for example, sacrifice half the death benefit by taking out half the cash value.

Explaining Dividends

Okay, the last odd thing about whole life insurance (which, weirdly, I never found particularly confusing) is the payment of dividends. When you sign up for a dividend-paying whole life policy, you’ll have the policy itself which offers you a guaranteed cash value over its life. In effect: things are predictable enough on average that the insurance company knows the buyout offers it is willing to make over time. But, you’ll also have claim to dividends which ARE NOT guaranteed. Where do these come from?

Here, we need to get into the old-timey structure of mutual life insurance companies. The basic idea: a bunch of people get together and pay premiums. This money is then invested fairly conservatively so that it can pay any expected expenses (people dying, agents’ commissions, etc.), and probably earns a bit more than that. So, what to do with the “bit more”? As with any business, it should go to the owners. So, who owns the insurance company? In a mutual insurance company, the policyholders do. So, the dividend goes, as it always does, to the owner.

Now, one option that you have is that you can use this dividend to buy more insurance in a paid-up fashion. Since paid up insurance provides a large % of cash value immediately, this is often a reasonable option, and is generally advocated by Infinite Banking/Bank On Yourself.

So, How About Infinite Banking/Bank On Yourself?

I’m going to save my analysis for the next post, but I do want to mention some important points about Infinite Banking/Bank on Yourself.

(1) Infinite Banking and Bank on Yourself advocates typically do not advocate buying just a basic whole life policy. The cash value builds up too slowly to be used for banking purposes. At the same time, they don’t advocate a plain-vanilla paid up insurance policy EITHER. They end up somewhere between using a couple of “riders”. The purposes: build up cash value as fast as possible WITHOUT triggering negative tax consequences.

(2) Nothing in this should be read as me advocating for Infinite Banking or Bank on Yourself. I am not a financial planner or financial advisor. I don’t even have a whole life insurance policy myself, and I’m still not decided whether it makes sense for me to do it. More to come on that. Each of us must make up our own mind. My goal in this post was just to explain some of how cash value actually works. This does, somewhat accidentally, answer one of the big criticisms of whole life insurance (not getting the cash value when you die).

Chapter 1 – The Lesson – In very brief, what distinguishes good economists from bad is that good economists consider the impacts of a policy on ALL groups and both the immediate term AND in the long run. Bad economists tend to focus on either the impacts on just one group, or on just the short run effects of a policy. (It is also technically possible for bad economists to focus only on the long run effects of a policy – but this seems to be a rare error today.)

Chapter 2 – The Broken Window – A hoodlum threw a brick through a baker’s window. People began gathering outside, and realized that this is a good thing for the economy. After all, buying a new window will create income for the glazier, who, in turn can spend this money on something else. On the surface, this seems right. It’s certainly true that the glazier and those who produce things he buys will benefit from this event. However, this ignores two sets of losers. (1) The baker himself has to pay to replace the window – that means giving up something else – say, a new suit. So, without the broken window, the baker would have had a window + a suit. Now, after replacement he simply has a window. (2) Had the window not been broken, the tailor would have gotten an income – as would those who produce the things the tailor would buy.

These are the Mises U selections from Garrison’s collection The Austrian Theory of the Trade Cycle and other Essays. The book is available from both the Mises Institute and Amazon.

Garrison – The Austrian Theory in Perspective – the Austrian business cycle theory (ABCT) incorporates capital structure in a way that Keynesian and Monetarist theories don’t. While ABCT doesn’t explain everything, it does provide the core theory for why business cycles happen. Details, however, are dependent on history and institutions. Thus, expositions of the theory will vary over time – and should! – as each exposition should reflect the concerns and institutions of the time.

Rothbard “Economic Depressions: Their Cause and Cure” – Any cycle theory should explain (1) the recurrence of business cycles, (2) the cluster of errors that gets revealed in the crisis, (3) the relatively large impacts on capital goods industries. ABCT does this by combining Humean arguments to explain recurrence, Mises’s argument about the information content of interest rates sending a false signal to entrepreneurs, and the relatively larger impact of interest rates on capital goods industries predicted by Austrian capital theory. To cure depressions, the government should refrain from credit expansion (which causes the problem in the first place, and can only prolong the malinvestments by covering up the errors as they grow) and cut back spending (freeing up resources for the private sector). This theory was on the edge of widespread acceptance until Keynes presented his theory – which did not refute Mises’s theory, but simply led many to forget about it.

Hayek’s “Can We Still Avoid Inflation?” – The answer: obviously yes, from a technical standpoint. However, politically, it’s not clear that it is possible, because, in industrialized countries, we have a combination of strong labor unions who will fight any drop in money wages – so that any change in relative wages requires that nearly all wages rise – and a central bank holding to a full employment policy – so they will increase the money supply in response to any increase in unemployment that the unions’ demand for higher wages brings about. [Lucas’s Note: Hayek’s essay is a bit dated. At least in the US, labor unions have seen a significant decline in recent years, and the Fed has developed a more balanced approach to employment and price inflation, and acknowledge that they have more impact on prices than employment in the medium to long run.]